This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers visit http://www.djreprints.com.

https://www.wsj.com/articles/SB920688868504214500

Other Voices

Of Little Faith

By

Ray Dalio

Updated March 8, 1999 12:01 a.m. ET

Order Reprints

Print Article

Text size

B razil's devaluation and the high interest rates investors are demanding for holding assets denominated in the Brazilian currency are the latest examples of how impractical it is for an emerging country to operate with a fiat monetary system. Such a system is one in which the currency is backed by faith -- faith that the government will follow policies that will defend the value of money at all costs, even the health of the economy.

Investors, both in and out of emerging countries, have learned that there is no basis for such faith. So they demand currency-risk premiums in the form of higher interest rates, raising the countries' cost of capital and hurting their economies. Ebbs and flows in this faith bring volatility to their currencies and interest rates, inflicting boom-bust cycles on their economies and markets.

For this reason, emerging countries should irrevocably link their currencies and, in turn, their monetary policies to something investors have more faith in, most practically an appropriate reserve currency. If investors knew --really knew -- that the link was assured, they would not demand currency-risk premiums to compensate them for devaluation risk.

When Brazilian interest rates jumped to more than 40% and the inflation rate was nil, just before the devaluation, the currency-risk premium was 20%. Paradoxically, those high interest rates, which Brazil was forced to give investors to compensate for the risk of the devaluation that authorities sought to prevent, forced the devaluation. As a self-confessed currency speculator, I can tell you that unsustainably high interest rates encourage me to bet on a devaluation. When people like me make this bet it raises interest rates even higher -- and with them the likelihood of devaluation.

In contrast, if there had been in place a viable currency board in Brazil -- about which more later -- there would have been little or no such betting, interest rates would have been lower and there would have been less downward pressure on the currency. If Brazil had a link to the dollar that the market really believed in, like Argentina's, what would have happened? Rather than rising to 40%, interest rates would have risen to about 20%, a premium of roughly 15 percentage points above U.S. rates to reflect Brazil's perceived default risk.

With Brazilian inflation nil, real interest rates denominated in Brazilian currency would still have been high, but probably not as high as now, even with inflation accelerating. That is because investors would not have demanded the high inflation and currency-risk premiums they now require, and the central bank would not have had to make money so tight to prove its inflation-fighting resolve.

In addition, lenders would have smiled on more Brazilian borrowers. Rather than retrenching because of both currency and credit risks, lenders would have pulled back only from those with significant credit risk; without a currency risk, neither Brazilian nor foreign investors would have felt compelled to flee high-quality securities denominated in Brazilian currency.

The country wouldn't have avoided recession because there was no escaping the need to reduce the current-account deficit to bring it in line with the reduced availability of capital. But capital would have been more plentiful, nominal and real interest rates would have been lower and the recession shallower. Most important, confidence in the value of money would have been maintained.

For capitalism to work, lenders must feel comfortable giving up their current buying power in exchange for promises that they will be given specified amounts of currency in the future. Unless lenders are confident that borrowers will deliver the promised amounts in currencies that will have value, capitalism won't work. The harsh reality is that very few countries' central banks inspire enough confidence to make having an independent, fiat-based monetary system viable.

I remember, when the gold-dollar based monetary system was abandoned in favor of the fiat system, how difficult it was to have such faith. I would say it wasn't until 1985-90 that there was broad acceptance of the fiat monetary system concept in a few countries. Now this system is assumed to be appropriate for almost every country, and asset-backed monetary systems -- where the tie is to gold or a hard currency -- are considered difficult to accept. The pendulum has swung too far.

Clearly, then, emerging countries should establish some sort of hard convertibility. Probably the most viable form is a currency-board system.

A currency board is a legally guaranteed monetary regime in which the exchange rate and convertibility between the local currency and a reserve currency is guaranteed both in law and by the 100% backing of the country's supply of money (the monetary base) with the reserve currency. The tougher the system is to repeal, the stronger it is.

Currency boards are not central banks in the traditional sense. They have no policies and they do not act as lenders of last resort. There is no judgment involved in their operations. They mechanically perform their function of increasing and decreasing the money supply based on how much of the reserve currency they have. Unlike currency pegs or free-floating exchange rates, which are managed by central-bank policy makers and have a nearly perfect track record of failure, the currency-board system is devoid of judgment and has a virtually perfect track record of having worked. Not only are the promised currency levels maintained, but the economic conditions are better as well.

To be sure, there are drawbacks to a currency-board system. Most obviously, a country gives control over its monetary policy to a central bank that manages the reserve currency but cannot act as a lender of last resort. Being forced to follow a monetary policy that is not consistent with one country's economic conditions certainly can be difficult. However, it is not insurmountable. Giving up the lender-of-last-resort function means that the central bank cannot monetize the banking system's liabilities. This can make the bumps in the road a lot harder, but it also provides the assurances lenders need to have confidence in the currency's value.

I believe evolution will drive many emerging countries to adopt currency-board systems over the next few years. More specifically, I expect that within five years, most Latin American currencies will be either dollar-linked or dollarized within a currency trade bloc that will broadly resemble the European Monetary Union. Similar currency blocs will emerge in Asia and perhaps even Africa.

In other words, the pendulum will swing about halfway back, to between the pre-'Seventies currency-backed Bretton Woods monetary system and the post-1970 fiat monetary systems. And that's the way it should be.

RAY DALIO is president of Westport, Connecticut-based Bridgewater Associates, which manages $14 billion in currencies and foreign bonds.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.